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These days, bond investors face several challenges, including an uncertain interest-rate environment, a sudden reversal of performance among high-yield bonds, and a potentially shrinking municipal market. Viewpoints spoke to Tom DeMarco, CFA®, a market strategist in Fidelity Capital Markets’ fixed-income division, about his outlook for interest rates, the current state of the high-yield bond market, and the supply-and-demand issues in the muni market.

What’s your outlook for interest rates?

DEMARCO: I’m hopeful we’ve seen the low in yields for this year, and that they may slowly start their way higher. I think rates may start to increase as the markets work through some of the weather-related issues that hurt economic numbers earlier in the year and continue to digest Fed tapering. That said, I’m not expecting a huge run-up in yields, and I think they may stay somewhat subdued in the near term.

Earlier this year, I expected the yield on the 10-year Treasury to hit 3.5% by year’s end. Now I’m looking for it to reach around 3.25%. There are a number of reasons for that lower estimate: One is the shortage of high-quality debt in the fixed-income market—some estimates peg the shortage at around $500 billion. And I think the slow pace of the economic recovery will continue to keep rates low.

High-yield bonds have trailed investment-grade corporate bonds this year. Why, and what’s the takeaway for investors?

DEMARCO: High-yield bonds tend to have relatively short durations, while investment-grade corporate bonds on the whole tend to have relatively long durations. Long-duration bonds have performed well this year. The further out you go on the yield curve, the better the returns were, all else being equal.

But does high yield really mean high yields anymore? In other words, are investors getting paid adequately for the risk they’re taking with these bonds? I’m not sure they are. I believe that the high-yield sector looks fully valued. The yield-to-worst on the Bank of America/Merrill Lynch High-Yield Index recently was just 5%, which isn’t a typical yield for this sector. That compares with an average yield of 9.56% since 1995, and 9.84% before the financial crisis.

Should investors be watching for signs of a shift in the credit cycle?

About the expert

Thomas DeMarco, CFA®, is the fixed income trading desk strategist for Fidelity Capital Markets. He provides the institutional tax-exempt and taxable trading groups and clients with general credit and market research as well as credit-specific analysis.

DEMARCO: Some signs out there have been noteworthy. For example, we’ve seen some slippage in corporate credit quality, as well as a greater percentage of new issuance at the CCC-rating spectrum and an increase in “covenant-lite” issuance. We’ve also seen more shareholder-friendly activity, such as special dividends and hostile M&A (mergers and acquisitions) activity. When you divert cash from corporate coffers to equity holders, it raises the risk for bondholders.

That said, Fidelity Capital Markets expects the default rate to remain quite subdued this year and into next year. So long as the economy continues to move in the right direction, that will help keep the default rate fairly low by historical standards. So while there are some stressors and some early indicators are flashing yellow right now, I don’t think there’s anything imminent that will cause the default rate to spike higher.

What has been driving performance in the muni market?

DEMARCO: Municipal bonds have been having a strong year. Supply and demand has played a big role in these results. Supply is down 23% compared with last year, and down 11% from the three-year average for the comparable time period. Fidelity Capital Markets forecasted roughly $285 billion in municipal bond supply this year. If that’s accurate, it would mean the market would be in a negative net supply situation, meaning redemption and coupon money is exceeding the supply of new debt. Meanwhile, more than $100 billion in coupon payments and redemptions is set to come back to muni investors through August. Theoretically, these technical factors should support a strong market. For now, buyers seem disciplined, and market activity is not exactly frenetic, but I think munis look attractive on an after-tax basis compared with other parts of the fixed-income market.

Low supply may be caused by a combination of factors, including increased direct bank lending, weak or uneven state revenues, and spending constraints. We’ve also seen a change in voter attitudes about debt—everyone seems to agree that infrastructure needs to be repaired or replaced, but no one seems to want to pay for it. Meanwhile, there’s some uncertainty in the municipal bond market over the uneven economic recovery and what will happen after the Fed finishes tapering.

We’re also starting to see the shrinking of the overall muni market. In terms of outstanding debt, the muni market has contracted by 2.7% since 2010, while interest rates fell 173 basis points through June 3 (and 290 basis points to the 2012 low in 10-year Treasury yields). In addition, while the amount of net tax-supported debt (NTSD) has increased, its year-over-year growth has plummeted. According to Moody’s, NTSD grew by a modest 0.4% in 2013, well below the 6.5% average annual growth in the past 10 years and the 1.3% growth rate in 2012. About half the states have experienced a decline in outstanding debt.

Growth in state-issued debt is slowing.

Source: Moody’s Investors Services.

Ordinarily, we might expect issuers to ramp up issuance after more than three years of restraint. But the unique factors we discussed earlier may mean that issuance remains subdued for a while longer and that outstanding municipal debt may continue to contract. If all this happens, it would help support the muni market from a technical perspective.

Are there areas of the muni market you think are particularly attractive?

DEMARCO: I think the economy will continue its recovery, even though it may not grow at a breakneck pace. So I look for areas that will benefit from this recovery, including tax-secured bonds, revenue bonds, and local general obligation bonds.

Two other sectors in the municipal market—taxable and high-yield muni bonds—have performed well this year, as investors have continued reaching for yield. That said, the high-yield muni sector can be challenging for individual investors, unless they’re extremely savvy in municipal analysis. I think investors generally are best served by adding exposure to high-yield munis through a mutual fund.

What does all this mean for bond-market volatility?

DEMARCO: When you have pretty firm central bank control over the market, you’re going to have low volatility. And the Fed has said that when it does raise interest rates, it will be methodical. But I think these long periods of low volatility may lead to potential issues down the road. When the Fed raises rates, it may not be able to control the market reaction the way it has thus far, and that may cause a spike in volatility, which we haven’t seen in a while. The message for investors is this: Low volatility may not end next week or next month, but don’t get lulled into complacency. Be vigilant and continue to look for relative value where you can.

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Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

The information presented above reflects the opinions of Thomas DeMarco as of June 13, 2014. These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization and are subject to change at any time based on market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund. Past performance is no guarantee of future results.

Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.

In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible.

Interest income earned from tax-exempt municipal securities generally is exempt from federal income tax, and may also be exempt from state and local income taxes if you are a resident in the state of issuance. A portion of the income you receive may be subject to federal and state income taxes, including the federal alternative minimum tax. In addition, you may be subject to tax on amounts recognized in connection with the sale of municipal bonds, including capital gains and “market discount” taxed at ordinary income rates. “Market discount” arises when a bond is purchased on the secondary market for a price that is less than its stated redemption price by more than a statutory amount. Before making any investment, you should review the official statement for the relevant offering for additional tax and other considerations.

The municipal market can be adversely affected by tax, legislative, or political changes and the financial condition of the issuers of municipal securities. Investing in municipal bonds for the purpose of generating tax-exempt income may not be appropriate for investors in all tax brackets or for all account types. Tax laws are subject to change and the preferential tax treatment of municipal bond interest income may be revoked or phased out for investors at certain income levels. You should consult your tax adviser regarding your specific situation.

The Bank of America/Merrill Lynch High-Yield Index is a market capitalization–weighted index of U.S. dollar–denominated below-investment-grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below-investment-grade rating (based on an average of Moody’s, S&P, and Fitch) and an investment-grade-rated country of risk. In addition, qualifying securities must have at least one year remaining to final maturity, a fixed coupon schedule, and at least $100 million in outstanding face value. Defaulted securities are excluded.

A CCC bond rating from Standard & Poor’s means the bond is currently vulnerable and is dependent on favorable business, financial, and economic conditions to meet financial commitments.

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